Yielding to pressure: Alternative investments may offer returns, but have risks, too

There qualification rules about who can invest including having a net worth that tops $5 million

Many Canadian investors are unhappy with their investment portfolio returns. Generational lows in interest rates combined with the Canadian resource-heavy market being one of the world’s worst performers during the past five years has made it challenging to produce the necessary returns to fund people’s current consumption patterns and expected retirement lifestyles.

But adversity is the mother of invention. Investors’ demand for yield and return has created a plethora of alternative investments that, generally speaking, are typically called exempt market securities and do not have a prospectus like stocks and bonds do. These alternative investments run the gamut from a single mortgage investment or an investment fund of mortgages to private real estate, private equity and hedge funds. Many exempt market securities are sold to investors as having less or even no market risk, but there are, of course, real risks that investors should consider.

First and foremost, not every investor can invest in exempt market products. The Canadian Securities Administrators (CSA) has rules that attempt to qualify only those investors who can bear the financial consequences of investments that go south. The most frequently used conditions to meet this accredited investor status are: financial assets (net of debt) of more than $1 million; income over $200,000 in the past two years or $300,000 when combined with a spouse; and a net worth topping $5 million (including real estate). Attaining these numbers may indicate that an investor is wealthier than average, but they don’t consider someone’s investing sophistication or their experience with complex and sometimes opaque legal and fee structures. In many cases, it is difficult to qualify and quantify what the true risks are for making an investment in an exempt market product versus something somewhat easier such as buying bonds or equity mutual funds.

In Canada, the majority of investors deal with investment advisers (formerly known as stock brokers) who recommend investments based upon the suitability standard. This means that the adviser needs to follow “Know Your Client” and “Know Your Product” rules and make recommendations that consider an investor’s net income, net worth, investment objectives and risk tolerance. Many investors think their adviser makes recommendations that are the best for the client, but other factors can come into play, such as the commission paid by the investment fund manager or the adviser’s firm. Quality of the exempt market investment plays a part, of course, but these considerations are sometimes overridden by the commissions or, in some cases, trailing fees paid to the adviser. Exempt market dealers in many, but not all cases, operate based upon the suitability standard.

An investor fortunate enough to hire an outsourced chief investment officer or family office that is registered as a portfolio manager enters into a fiduciary relationship where the interests of the client must come first. Clients pay the firm directly and the portfolio manager accepts no other forms of compensation. While seemingly innocuous, acting as a fiduciary poses significantly more challenges than following the suitability standard. Investors should look for firms that have extensive experience in performing due diligence on a variety of asset classes and whose professionals hold credentials such as chartered financial analyst, MBA, chartered alternative investment analyst or even chartered business valuator.

There are a number of basic questions investors should have when beginning to perform due diligence on an exempt market investment. For example, what is the liquidity of the investment? Depending on the asset class and structure of the investment fund, lockups may range from 30 days to 10 years and beyond. A related question is when do investors get their capital back? Is the fund reported on Fundserv (which operates as a back office that allows banks and dealers to price the reported fund on a frequent basis) or through a private limited partnership structure that could be registered in Canada, the United States or an offshore jurisdiction such as the Cayman Islands? In addition, investors should find out what and how the fees are calculated, how much capital the fund’s managers or general partners have placed into it, and what the secondary market is, just in case they need to downsize their position.

These questions are just the tip of the iceberg with regards to performing due diligence, and don’t address issues such as fraud by the investment fund or an adviser directing client monies to a firm owned or controlled by the adviser. Previously rare, the number of investors hurt by fraud will likely only grow given the proliferation of exempt market investments over the past five years.

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Eric Ni

Partner of CAN Partners LLP

Financial auditor and advisor since 2006

Extensive experience in both US GAAP and IFRS reporting frameworks

Assisting companies going public and improving internal control and compliances to meet regulatory requirements

Master Degree of Management and Professional Accounting, Rotman School of Business, University of Toronto

Bachelor Degree of Law, Soochow University

Lorne Saltman

Partner, Gardiner Roberts LLP

Bar Admission, Ontario, 1973

Extensive experience in diverse areas of tax practice, including in-depth experience on both the international and domestic levels involving wealth preservation for high-net worth clients, cross-border acquisitions and financings, corporate reorganizations, real estate ventures, and the establishment of offshore trusts and private foundations.

Successful track record in resolving disputes with tax authorities at both the federal and provincial levels, including some experience in tax litigation.

Memberships:

American Bar Association, Business Law Section, Taxation Committee, Advisory Panel

American Bar Foundation

Canadian Bar Association

Canadian Tax Foundation

Hague Academy of International Law

International Bar Association

International Commission of Jurists

International Fiscal Association

International Tax Planning Association

Ontario Bar Association

Society of Trust and Estate Practitioners (STEP)

Toronto Chinese Community Services Association

Academic Background:

Juris Doctor, Osgoode Hall Law School

Bachelor of Science, University of Toronto

Michael Cadesky

Managing Partner, Cadesky Tax

In full-time income tax practice since 1980

Vice-chair, CPA Canada Tax Committee for Small and Medium-Sized Enterprises